Ordinarily, investors fret when companies have to write down the value of shoddy investments. "Write-downs," "write-offs," "mark-to-market adjustments"—whatever you want to call them—are admissions that a company woefully overestimated the value of assets on its books. Write-downs should be especially worrisome when taken by banks, since they are in the business of valuing financial instruments. And yet in recent weeks, as the nation's blue-chip investment banks—Bear Stearns, Merrill Lynch, Citigroup, and others—have announced multibillion-dollar write-downs because of poor lending decisions, their stocks have risen.
What's the reason for the shareholder confidence? Egged on by bank executives, investors have come to believe this is the extent of the damage. We'll take these write-downs and no more! The credit problems are over! Let's move on!
Investment bank CEOs and their shareholders clearly believe that the worst is over. But a fine line separates belief from credulity, and the large investment banks are blurring it.
Throughout 2007, the credit situation has progressively deteriorated. Subprime mortgages went bad, and then the rot spread into other classes of debt. While sharpies like Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke declared the subprime virus to be contained, it was infecting the rest of the financial nervous system. Even as recently as a couple of months ago, the big banks were clueless as to the ravages of the deteriorating credit environment. When Merrill Lynch reported second quarter earnings on July 17, CEO Stan O'Neal boasted about various records. As the Wall Street Journal noted, Chief Financial Officer Jeff Edwards said at the time that Merrill Lynch's exposure to subprime was "limited, contained and appropriate." Yet on Oct. 5, 12 weeks later, Merrill announced that the subprime impact was neither contained nor appropriate. "Challenging credit market conditions" would cause it to take write-downs of $4.5 billion on subprime mortgages and other debt instruments. On July 20, when Citigroup reported second quarter earnings, CEO Charles Prince likewise crowed about broken records. But on Oct. 1, Citigroup said it would have to take nearly $5 billion in write-downs because of the credit catastrophe.
In other words, having utterly failed to predict the trouble they encountered in the summer, bank CEOs are nonetheless assuring shareholders that the worst is over, and that the trends that hurt them this quarter—problems in subprime, concerns about consumer credit, and uncertainties about debt extended for corporate buyouts—won't affect business unduly in the next quarter. "We expect to return to a normal earnings environment in the fourth quarter," as Citigroup's Prince put it.
The banks got caught up in the credit bubble just like everybody else. In September 2006, Merrill Lynch paid $1.3 billion for subprime lender First Franklin, after the subprime market had peaked. Last July, when signs of excess were apparent in the buyout market, Citigroup CEO Chuck Prince said: "As long as the music is playing, you've got to get up and dance. We're still dancing."
When a bubble bursts, the key players always rush to call a bottom, to declare the worst over. Yet they almost always have to call another bottom a few months later when things deteriorate even more. The reckoning, while frequently swift, is rarely completed in a single quarter. Just ask the home builders, who repeatedly said the housing market was stabilizing, only to ratchet back earnings over and over again. Now we're seeing the same retreat with banks. On July 18, mortgage giant Washington Mutual reported that its home-lending business was improving. The unit notched a $37 million loss in the second quarter, much better than the $113 million loss suffered in the first quarter "as a result of more stable market conditions for subprime loans." CEO Kerry Killinger said the unit was "targeting a return to profitability by the end of the year." But on Oct. 5, Washington Mutual said the market for subprime loans had destabilized again. "A weakening housing market and disruptions in the secondary market" would cause net income to fall by hundreds of millions of dollars in the third quarter.
Of course, forecasting is hard. This summer's market gyrations surely caused unexpected losses. But the factors behind them—the slowing housing market and the mounting delinquencies in subprime—were entirely evident in the first and second quarters. And even after taking write-downs, all these banks still are exposed to the kinds of assets that caused them trouble in the first place. At the end of the third quarter, Merrill Lynch still had $31 billion in loans committed to buyouts or private equity firms, down from $53 billion at the end of the previous quarter, while Citigroup—those dancing fools—had $57 billion in such commitments. All the banks have significant exposure to mortgages, and to credit cards, the latest asset class in which delinquencies and write-offs are likely to rise.
The write-downs are confessions by investment banks that they hadn't put aside enough reserves to account for bad debts and that they threw restraint and caution to the wind in committing loans and capital to frothy sectors. Investors have clearly absolved banking CEOs of their sins. But not all sinners—not even the ones who are $5 billion worth of sorry for their mistakes—learn enough from their sins to stop sinning.